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The Day Ahead: Web brokers' profits can't buy Wall Street's love

These are good times for online brokers, but you'd never know it by looking at their stock prices
Written by Larry Dignan, Contributor

Online brokers such as E*Trade, Ameritrade, DLJdirect and Charles Schwab all creamed Wall Street estimates and delivered stellar quarterly results.

E*Trade broke even in the first quarter when First Call consensus estimates pegged the company for a loss of 16 cents a share. The brokerage showed that its hefty marketing budget is worth the price.

For the quarter ended March 31, E*Trade’s net revenue grew to $407m (£260m), up 152 percent from the same period a year ago. The online broker also attracted 603,000 new accounts.

"We continue to look favourably upon the future prospects for E*Trade," says Bryan Keane, an analyst at Prudential Volpe Technology Group. "The company has entered continuing operations profitability six quarters ahead of schedule, flexing its blue-chip Internet business model."

What kind of response did E*Trade get for those results and analyst comments? E*Trade closed at $22 3/4 on April 12, the day of the earnings report, and hit $18 two days later in the tech downdraft. E*Trade closed Monday at 20 13/16.

Ameritrade ran into the same wall. On April 13, Ameritrade did E*Trade one better and posted a surprise first quarter profit of 2 cents a share on revenue of $170.3m. The company also added 319,000 new accounts. Not too shabby, but not enough to keep shares afloat. Ameritrade meandered around $14 for a few days before showing a slight rebound. Ameritrade closed Monday at 16 5/16.

DLJdirect had the same problem -- nice profit, weak stock price. Why? The consensus on Wall Street is that first-quarter volume and profits won't last.

"Investors are concerned about the June quarter," says William Wong, an analyst at Josephthal. "The Nasdaq sell-off sparked concerns that trading volume will drop. The activity last quarter is not sustainable."

The volatile stretch of trading among tech stocks also informed investors that stocks can fall as quickly as they rise. That reality could hurt trading volume, which drives revenue and profits at the online brokers.

Meanwhile, margin trading has been pegged as one of the reasons the Nasdaq was so volatile in the first place. Typically, an investor can borrow up to half the value of his or her stocks. Once the purchase is complete, the value of the stock minus the amount of the loan must equal at least 25 percent of the market value of the shares. When stocks tank, margin calls happen. That means investors have to put up extra cash or sell shares to meet broker requirements.

Many investors were borrowing from online brokers -- at very lucrative rates -- to trade. If margin trading declines or is capped, brokers may lose a good revenue stream.

E*Trade Chief Executive Christos M. Cotsakos tried to assuage investors' fears in a letter to account holders. "No one can deny it, the market has recently moved sharply in both directions," he wrote. "Especially in times like these, it's important that all investors, myself included, need to take a step back to think about where we've been and where we're going so we don't overreact."

Investors may not heed Cotsakos' advice, but Wall Street analysts are following it.

"It's too early to tell what effect the volatility will have on online brokers," says Wong. "These companies have been adding so many accounts. I'd rather have the accounts than the transaction revenue."

Stock brokerages often act as banks for their customers and look to make a sizable chunk of their revenues managing the captive assets. Wong says online brokers have been focused on acquiring assets to lessen their dependence on commission revenue. E*Trade had $65bn in customer assets at the end of the second quarter and Ameritrade had $38.9bn.

"Acquiring customers is key right now," said Wong. "The online brokers have probably bottomed out, but exercise caution."

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